When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop ‘solutions’ less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

If even just a few communities default on their insured debt, many others would likely be downgraded or cut off from the capital markets altogether – whether they risk default or not. Perversely, even healthy municipalities could be left with little choice but to default.